Compound interest is a tool for growing savings and building wealth. Because various options exist, understanding how compound interest works could be helpful for choosing the right account to match your goals and maximize savings growth.
How does compound interest work?
Compound interest is earned on both the principal (the initial deposit) and the accumulated interest. Over time, interest is earned not only on the original amount but also on the previously earned interest, leading to growth and accumulation.
How do you calculate compound interest?
There is a known formula for calculating future values of investment or loans with compound interest. To keep it easy, you can explore on your own to find reliable online calculators to determine this. Here’s an example—let’s say you make a $5,000 investment at a 5% annual interest rate compounded monthly for 20 years. After 20 years, your account would grow to approximately $13,563.20, earning about $8,563.20 in interest.
Simple Interest vs. Compound Interest
Simple interest is calculated only on the principal and the interest earned remains constant. Compound interest is calculated on the principal and the accumulated interest. This means that interest grows exponentially. Let’s take the $5,000 investment at 5% interest rate example from above. If we plug that information into and available simple interest calculator, we see that at the end of 20 years the account would grow to approximately $10,000, notably less than the account with compound interest. The separation between the accounts grow each year due to the exponential growth of compound interest.
How can I earn compound interest?
Compound interest is earned in accounts that offer it. Different accounts offer varying interest rates, compounding frequencies, and terms, all of which impact long-term growth. Understanding these factors is essential for selecting the right account.
Common Compound Interest Accounts:
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Savings Accounts:
Savings accounts are a simple way to earn compound interest. Many banks compound interest daily, monthly, or annually. Some online banks often offer higher interest rates. However, traditional savings accounts may have lower rates and limited monthly transactions. •
Certificates of Deposit (CDs):
CDs offer higher interest rates than savings accounts in exchange for a fixed term. Interest is typically compounded quarterly or annually. CDs offer predictable returns but limited liquidity; funds cannot be accessed without penalty before the term ends. •
Money Market Accounts:
Money market accounts may offer higher interest rates than regular savings accounts and often compound interest monthly. They combine features of savings and checking accounts, providing easy access to funds. However, they may have higher minimum balance requirements and transaction limits. •
Savings Bonds:
Savings bonds accumulate interest over time, typically compounded semi-annually. For example, Series EE bonds double in value after 20 years. Interest is tax-deferred until the bond is cashed in. •
Annuities:
Certain annuities, like fixed and variable annuities, can earn compound interest. o Fixed Annuities: Offer a guaranteed interest rate, compounded typically annually. o Fixed Index Annuities (FIAs): Link growth to a stock market index, offering potential for growth while protecting premiums from market downturns. Interest is compounded, and earnings will not be less than zero. o Variable Annuities: Invest in underlying securities like stocks and bonds. Returns are not guaranteed, but interest can compound based on investment performance. •
Retirement Accounts (IRAs, 401(k)s):
Retirement accounts use compound interest to grow savings, especially when invested in stocks, bonds, or mutual funds. Regular contributions and long-term growth potential are key benefits. These accounts often offer tax advantages. •
Investment Accounts:
Brokerage accounts that reinvest earnings (dividends, interest) generate compound interest. Potential for higher returns exists, but so does the potential for loss.
Can I Earn Compound Interest on Life Insurance?
In addition to death benefit protection, some life insurance policies accumulate cash value through compound interest. •
Whole Life Insurance:
Typically has fixed premiums, guaranteed cash value growth, and dividends that may compound. •
Universal Life Insurance (UL):
May have flexible premiums and cash value growth potential tied to interest rates. •
Indexed Universal Life Insurance (IUL):
Offers potential cash value growth linked to the performance of a stock market index, with a minimum interest rate guarantee.
Understanding the Power of Compound Interest
Consulting a financial professional can provide valuable guidance and expertise for making informed decisions about compound interest and your financial goals. They can help you explore various accounts and investment options to achieve long-term financial success.
Insurance products are not bank deposits, and are not insured by the FDIC/NCUA or other regulatory agencies. They are not obligations of or guaranteed by the financial institution or other affiliated entities, and are not a condition of a loan.
Variable insurance products are subject to market risks and may lose value, including loss of premium.
Neither North American Company for Life and Health Insurance® nor its agents give tax advice. Please advise your customers to consult with and rely on a qualified legal or tax advisor before entering into or paying additional premiums with respect to such arrangements.
The term financial professional is not intended to imply engagement in an advisory business in which compensation is not related to sales. Financial professionals that are insurance licensed will be paid a commission on the sale of an insurance product.
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